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Friday, July 4, 2008

The Economist Magazine Forgot This Global Institution in Its Leader

The Economist has an interesting leader on the future of global institutions such as the G8, the IMF, and the UN Security Council. The article, however, makes a glaring omission when it comes to its list of important global institutions. This oversight, though, may be a good thing since there is no point in reminding the world about a highly influential global institution that is largely indifferent to the needs of the world yet highly concerned about the one country that runs it.

So what is this global institution? Let us turn to the Financial Times for the answer:

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian [and many Middle Eastern] countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

So the Fed is a monetary hegemon and its current accommodative stance, while arguably appropriate for the United States, is way too stimulative for the dollar block, those countries whose currencies are tied to the dollar. This is creating some geopolitical angst and is why the Fed should be added to the list of important global institutions.* The global reach of the Fed is something I have discussed before, but recent commentary on this issue by Brad Sester started me thinking more about the fundamental problem with this arrangement. Here is Brad Sester's take on these developments:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

...Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Brad's point is that this arrangement is the one of the main reasons for the global economic imbalances--the large, ongoing U.S. current account deficits and the financing for them from Asia and the Gulf region--and is therefore unsustainable. I agree with Brad's conclusions, but have started thinking about this problem from a different perspective: the dollar bloc an optimum currency area (OCA). Consider the standard criteria of an OCA: similar business cycles, mobile labor, flexible prices/wages, fiscal transfers, diversified economy. The main regions of the dollar block--U.S., Asia, and the Gulf region--fail to meet the OCA criteria on most counts. For example, the U.S. economy is slowing down while the rest of the dollar block is overheating. Or, when was the last time you saw a mass exodus of former Rustbelt workers moving to China or heard of a fiscal transfer from the Gulf region to the Rustbelt? By my reckoning, then, the OCA criteria also indicates the dollar block countries should abandon their pegs and take on more monetary policy autonomy.

With that said, I am fearful of what would happen to the U.S. economy if the dollar block countries abandoned their dollar pegs anytime soon. The Fed's job would certainly be made more challenging and potentially there could be a run on the dollar. In the near term, then, it may be more sensible for the Fed to acknowledge its role as a monetary hegemon and take the lead in fighting global inflation. (Actually, I would have the Fed stabilize global nominal spending, but I digress). This may have some domestic economic consequences, but it would (1) help reign in global inflation and (2) give more time to dollar block to hammer out a coordinated plan of separation.

*According to Ken Rogoff, these countries make up about 60% of the global economy so the Fed's influence is significant.